#rotmanmba

Last night I had the pleasure of being on the judging panel for a new generation of the Rotman Value Investing class. 10 groups of students had 11 minutes each to present one stock pick each to the rest of the class and panel. It's a mind boggling task. In 11 minutes you have to convey an industry, a company, a strategy, a story, a technical valuation that includes heavy financial modeling, and recommendation to a group of people who may or may not have heard of the company you are proposing.

The teams did a great job. The presentations were well prepared and rehearsed, with some solid analysis backing up the recommendations. Most importantly, there was conviction and passion behind the recommendations.

And I should say that 2014-2015 is going to be very tough for value investors. In a fairly valued market, it is extremely difficult to find good companies that are also undervalued. Not surprisingly, there were several recommendations that covered micro or small cap companies as well as companies in undesirable markets or companies with significant legal and regulatory risks.

The judging panel did have some feedback and questions, especially those in the panel who have been doing this for a long time. I'd like to walk you through a couple of themes below.

What's The Story?

This was a recurring theme with the panel. Some teams presented strong companies and strong arguments why an investor should buy into them. However, at times they did not quite convey why the market undervalued the company. Why did they believe that they had an opportunity to buy a company at a discount? Why did the market get it wrong?

The market could be pricing in hidden litigation risks, expectation on commodity prices, or expectations on changing regulations. It is imperative to understand the market's assumptions so that you can tell the right story.

Small/Micro Caps Need Liquidity and Governance

The other theme that came up touched on the micro cap or small cap recommendations. Most of these were stable family business that had grown over decades to become public companies. The financials were strong and the investment themes tended to focus on the lack of analyst coverage on these firms. That is, the company is flying under the radar.

However, micro cap stocks have some hidden dangers. First, they may not have enough liquidity to support an institutional investor. If a fund needs to put $1, $5, or $10 million in a position, they need to know that when it comes time to sell, they can do so. There needs to be enough market for the company's shares and enough turnover.

Secondly, family run companies carry governance risks with them. Families and owner managers can sometimes pursue interests other than shareholder returns. They can hire a management team within the family rather than outside professionals. And families like to have control of their businesses, which means they are likely to have a strong controlling interest in the equity of the company. This could be a big challenge for other shareholders who want to have a say in the direction of the firm.

So if you are going to buy into a small or micro cap company, you need to ask extra questions around liquidity, share ownership, and diversity of directors and managers.

I look forward to the next round of presentations in the winter. I have a feeling the current tough environment isn't changing any time soon.